It is not an uncommon practice for a client to bring his or her money to a broker dealer for investing to grow their wealth. When this happens, how does your broker dealer invest it? Are there precautions in place to prevent your broker dealer’s registered representatives from mismanaging those funds?

One type of mismanagement is excessive trading, also known as churning. This happens when a registered representative excessively buys and sells securities in a client’s account for the primary purpose of generating commissions instead of focusing on what is best for the client. While greed is usually the motivating factor for the registered representative, it comes at the cost of the client’s portfolio.

In an effort to continuously protect investors, the Securities and Exchange Commission (“SEC”) and the Financial Industry Regulatory Authority (“FINRA”) have established rules and regulations in regard to excessive trading. Key rules and regulations include:

  • Know Your Client & Suitability Rule: Broker dealers must have a clear understanding of a client’s financial situation, investment objectives, and risk tolerance before making any recommendations.
  • Churning Rules: Broker dealers must evaluate all the factors when placing trades such as turnover rate, cost-to-equity ratio, and the client’s overall investment strategy.
  • Margin Trading: Regulations dictate that broker dealers must obtain written consent from clients before engaging in margin trading, which can be risky and potentially lead to excessive trading.
  • Disclosure: Broker dealers are required to disclose their compensation and any potential conflicts of interest to the client.

Several reasons why churning can be detrimental to a client’s account are listed below:

  • Increased Costs: Frequent trading leads to higher transaction costs, which can eat up the client’s overall return.
  • Capital Erosion: Excessive trading can erode the client’s capital due to the bid-risk spread, taxes, and other transaction related expenses.
  • Unsuitable Investments: A broker dealer may push clients into high commission investments that are not in the client’s best interest.
  • Potential Losses: Frequent trading can lead to poor investment decisions and significant losses.

Broker dealers are extremely valuable to the growth of a client’s portfolio and investment journey. It is imperative that both the broker dealer and the client always stay vigilant and aware of the potential for excessive trading. If your broker dealer would like to discuss the rules and regulations set forth by the SEC and FINRA, please contact Master Compliance here to speak with one our compliance professionals. Our team of consultants can help your broker dealer set forth the standards necessary to protect your broker dealer and your clients from churning.